1. High level decline: the beginning of a trending downward trend

In November, the finished product market experienced a significant decline, with both steel prices and market trading volumes showing a clear decline. In just over two weeks, finished product prices dropped directly from a high around 4800 to around 3800. The expected heating season production restrictions did not support the cold winter market like last year. Although many people attributed the decline to seasonal weakening of demand afterwards, the timing and magnitude of the decline showed that this wave of decline was different from the past.

If we look at the inventory data again, we will find that the social inventory of rebar has been continuously hitting historical lows since October. While steel prices fell the most in November, social inventory has actually reached a point where there is no way to reduce it. In some areas, there are even shortages of specifications, but prices have not improved at all, which is completely different from the booming market in the same period last year. The low inventory level actually reflects the weakening of speculative demand and the lack of market confidence.

What is the market really worried about? Starting from the fundamentals of steel, we can explore that the performance of both the supply and demand sides of steel this year has exceeded expectations. Although environmental production restrictions have been ongoing since the beginning of the year, supply has remained at historically high levels during the same period. On the other hand, the apparent consumption of steel spot goods has remained at a high level until now, which means that the increase on the supply side this year has been completely absorbed by the increase on the demand side. Although environmental restrictions on production have always been the driving force for market speculation on steel price increases, the fundamental reason for the long-term high price of steel is actually the strong demand. The root cause of the lack of market confidence lies in the fact that the high increment of supply next year will maintain inertia, while the high increment of demand is difficult to sustain. The result of this trade-off is that the market will shift from scarcity to looseness.

The endogenous driving force for increasing production on the supply side is unprecedented high profits in the industry. Since 2016, the profits of the steel industry have continued to increase, and the balance sheet has continued to improve. In 2018, the gross profit of steel mills per ton remained at a level of 1000 yuan/ton for a long time. According to reports, from January to October, the steel industry in Hebei Province achieved a profit of 81 billion yuan, a year-on-year increase of 49.41%, accounting for 37.99% of the province's industrial enterprise profits. Driven by high profits, steel mills are engaged in a fierce game between increasing production and policy restrictions.

In order to counteract the impact of environmental production restrictions on supply, long process steel mills have begun to make process adjustments, with increasing the grade of ore entering the furnace and the proportion of scrap steel added becoming the main means. For short processes, electric arc furnaces have obvious advantages in environmental protection and have been included in the list of exempted production restrictions. With the profit window open, a large amount of production capacity has been put into operation, and the utilization rate of production capacity has been greatly improved. The final result we see is a differentiation in the production growth of pig iron and crude steel, and "limiting iron but not steel" became the norm in 2018.

In addition, after three years of capacity reduction, the government's plan to reduce steel production capacity by 100-150 million tons in the next 3-5 years, which was proposed in 2016, has now been fully completed. The targeted capacity reduction will come to an end, and the future will mainly control steel production capacity through reduction and replacement. At the same time, the environmental protection facilities of steel enterprises are becoming increasingly perfect, and the authority to implement production restrictions has been delegated to local governments. In the future, the impact of environmental restrictions on the market will gradually weaken.

In short, the spontaneous adjustment of the industry and the shift in policies have brought opportunities for the steel industry to increase production. From January to October 2018, crude steel production reached 780 million tons, and it is estimated that the annual crude steel production will be 930 million tons (830 million tons in 2017). This also indicates that the supply potential of the industry's on balance sheet production capacity is far beyond expectations.

Looking at the demand side again, the three major areas of downstream steel consumption are real estate, infrastructure, and automobiles. Among them, real estate directly contributes 30% to steel consumption. The sustained boom in new real estate construction this year is the main support for the growth of steel consumption, with a cumulative increase of 16.3% in new real estate construction from January to October. However, there is currently no sign of relaxation in the government's regulation of the real estate market. In order to avoid a major impact on the real estate market, it is difficult to release the supply of real estate, which determines that the real estate market will be in a tight supply pattern for a period of time in the future. On the other hand, in order to curb the rise in housing prices, the free trading of houses is also strictly controlled. Therefore, in the medium term, real estate will become a low liquidity asset, and the willingness of capital to enter will weaken. The high growth of real estate investment and new construction is difficult to sustain. Currently, the completion and sales of the back-end have entered a clear downward channel.

Since July, the government has repeatedly stated its intention to increase fiscal spending and address the shortcomings in infrastructure. The market once had high expectations for this, but based on the current situation, the scale of infrastructure investment is limited. Even if infrastructure investment expands, the demand increase it brings cannot make up for the reduction in real estate. In addition, due to the debt constraints of local governments, the expansion of infrastructure investment is also suppressed.

The domestic automotive industry has fallen into a slump and there is no possibility of recovery in the short term. In the past few years, the number of cars owned by domestic residents has experienced rapid growth and encountered bottlenecks. In the next few years, as durable goods, the main demand for cars will come from stock replacement, with a relatively small net increase. At the same time, the rapid rise in residents' leverage ratio and the tightening of bank credit will limit car consumption.

Overall, the expansion trend of the supply side and the contraction trend of the demand side in the future will once again put the steel industry at risk of oversupply, and the sharp decline in November is not simply a seasonal weakness, but the beginning of a downward trend in the industry.

2. Excess dilemma: an inescapable gray rhino

If we look at the issue of surplus over a longer period of time, we will find that the steel industry is currently at a transition point between prosperity and decline. Generally speaking, the inventory cycle of the industry is usually 3-4 years. However, in reality, due to changes in the external environment and policy intervention, the complete inventory cycle of the steel industry lasted for seven years from 2011 to 2018. Especially from 2014 to 2016, local governments provided a large amount of blood transfusion to some steel enterprises under the pressure of "maintaining growth" and "maintaining employment". While inefficient production capacity was able to survive, the duration of the industry's depression period was also prolonged. In 2016, the government began implementing a tough supply side reform policy. After a brief recovery period, the industry embarked on a two-year period of prosperity. However, the situation of this policy forcibly pushing the cycle is already abnormal. The longer it lasts, the more obvious the drawbacks become. The more energy is lost, and profits accumulate upstream. The prosperity of the steel industry has become an unbearable burden for downstream industries. After the policy adjustment this year, the industry inevitably entered the next lifecycle.

Looking back at the development process of the domestic steel industry in the past 20 years, the topic of overcapacity reduction in the steel industry has been around for a long time. In 2006, the State Council issued a notice on accelerating the structural adjustment of overcapacity industries, and the steel industry was already included in the list of overcapacity reduction. In 2013, the State Council issued another guidance on resolving the serious overcapacity contradiction, and the steel industry remained on the list. By 2015, the State Council had issued another opinion on resolving overcapacity in the steel industry to achieve development. After 9 years, this problem had not been effectively solved, and there was even no significant improvement. Today, the trend of continuous expansion of domestic steel production capacity has not stopped.

Why hasn't the crisis of surplus erupted on a large scale? The root cause lies in the expansion of supply while the demand side is also expanding, or in other words, the excess risk on the supply side is temporarily digested by the increment on the demand side. In 2008, the global financial crisis hit, and the government adopted fiscal stimulus measures to stabilize the economy. From 2009 to 2013, domestic infrastructure and real estate entered a high-speed development stage. From 2016 to 2018, real estate destocking and monetization of shantytown renovation greatly pushed up housing prices, and subsequently opened up another boom in the real estate industry. It is not difficult to find that the driving force behind the two rounds of growth in real estate and infrastructure is not from the industry itself. The traces of administrative intervention are very obvious, and anything that goes too far is not enough. Currently, the real estate market is in a delicate balance and it is difficult to act as an engine again. So back to the steel industry, the risk of overcapacity has always existed, like a grey rhino that has never been shaken off. We have delayed the outbreak of the crisis by increasing demand in the past few times, but this time it is urgent to face the problem head-on.

When an industry faces a crisis, whether to rely on market forces or administrative intervention to solve the problem has always been a difficult problem for decision-makers. The perfect combination of the two is beneficial for the industry to quickly overcome difficulties, but more often than not, market and policy forces will inevitably engage in games and internal friction. We believe that the following three measures should be taken for the future: (1) allocating resources through the market, opening up free competition in the industry, eliminating the fittest, and allowing the industry to enter a natural decline period; (2) Deepen supply side reform, continue to raise industry entry barriers (ultra-low emissions&new national standards&large-scale blast furnaces), and forcibly eliminate the bottom tier production capacity; (3) The demand side is once again making efforts to introduce new driving forces for industry growth (investment&export&consumption).

These three methods are not contradictory, but a combination of punches. The first point is reflected in various steel production capacity reduction documents released. The second point is being continuously implemented, but there is a suspicion of overcorrection and has been adjusted. The third point is consistent with the recent Central Economic Work Conference's proposal of "stabilizing total demand". Comparing the experience of reducing production capacity in the steel industries of the United States and Japan, the first approach is the fundamental solution to the problem, the second can serve as an auxiliary, and the third can buffer the impact caused by the reform process. Based on the above analysis, we predict that the domestic steel industry will gradually enter a period of decline and embark on substantial transformation and upgrading in the future.

3. The end of prosperity: high profits that will eventually fade away

Due to the financial nature of steel, fluctuations in steel prices are amplified by short-term events, resulting in significant uncertainty in predicting the trend and pace of steel prices next year. However, it is certain that the industry will enter a recession period, and the center of gravity of steel prices will shift downwards, leading to a contraction in production profits. As is well known, the high profits of the industry in the past two years are the dividends of supply side reform. More specifically, this high profit comes from the supply shortage caused by administrative intervention. In the absence of an increase in total profits, the profits of the industrial chain are redistributed and continue to accumulate upstream.

In the context of adjusting the supply side reform in the future, the decline in profits in the steel industry is necessary, reasonable, and feasible. The necessity lies in balancing upstream and downstream profits at the policy level, reducing the costs of downstream industrial enterprises, and enhancing the ability of the entire industrial system to resist external risks. Rationality lies in the fact that differentiated competition is conducive to achieving cost reduction and efficiency improvement in the industry. The current situation where the entire industry is in a comfort zone is unreasonable and not conducive to the long-term healthy development of the industry. The feasibility lies in the fact that the industry has already shown signs of decline, and without excessive intervention, it is natural for competition to intensify.

Profit, as the core driving force of enterprise operation, is bound to trigger industry changes when profits decline. Therefore, the first competition that will arise will be the competition in process costs, namely the competition between long processes (blast furnace converter) and short processes (electric arc furnace). In the long process steelmaking process, costs can be adjusted by adjusting the blast furnace inlet grade and scrap steel addition ratio. Compared with the short process process that relies entirely on scrap steel resources, the long process has stronger resilience in dealing with profit declines. Therefore, in the first stage of profit decline, short process steel mills will be the first to reduce production, and profits will continue to decline. Long process steel mills will adjust their material habits and their preference for high-quality ores will decrease. The second stage of profit decline is the competition of individual costs among enterprises. Enterprises with advantages in cost reduction and efficiency improvement will ultimately win. As some enterprises experience a shortage of funds, the last production capacity begins to exit the market. At the same time, mergers and acquisitions of enterprises accelerate, ultimately achieving industry balance.

This rebalancing process corresponds to the decline and depression of the industry, and the duration of this process depends on the role played by policies. Positive guidance will accelerate the industry's recovery, while indiscriminate assistance will slow down the industry's transformation process. The first stage has already begun.

4. Forge ahead: Hand in hand to traverse through the darkest moments

Looking ahead to 2019, the Chinese economy is facing enormous challenges at the macro level, with the long-term and arduous trade war between China and the United States, domestic economic growth facing bottlenecks, and various reforms entering a deep water zone. At the industrial level, the steel industry is shifting from full profit to differentiated competition, inevitably facing a downward shift in the focus of finished material prices and a contraction in profits. Against this backdrop, it is difficult for coal coke and iron ore on the raw material side to break out of the trend oriented market. Specifically in terms of investment, the overall strategy is to short sell at high prices, but it is important to note that pessimistic expectations can overdraw prices in advance. In terms of the relative strength of the varieties, it is expected that coke>coking coal>iron ore>thread>hot coil. (Bulk internal reference)